Comment: Securities Exchanges Must Reinvent Themselves

Given the unprecedented turmoil that securities exchanges around the world are experiencing, it is fair to wonder if they still have much of a future. The answer is "yes, but." To survive, exchanges will have to go through radical change.

For the many global banks that have brokerage activities on derivatives or equities exchanges, the evolution of exchanges will create new challenges-profit pressure as well as new opportunities. Consider the trends and events of the last year or so.

Rapid penetration of electronic trading in derivatives and stock exchanges.

Major declines in seat prices, ranging from 30% to 80%, depending on the market and type of seat.

Mergers and strategic alliances of exchanges worldwide.

Demutualization and privatization of exchanges.

What is going on and why is the traditional business model of exchanges under pressure?

Exchanges were typically set up like private clubs where you had to purchase a seat and trading was handled by open outcry on a floor. Exchange members, therefore, have always been among the first to resist screen trading because it would eventually level the playing field, making the same information available to anyone with a trading screen.

Exchanges, as businesses, have historically been run as quasi nonprofits. They charge listing fees for stocks, transaction fees, and clearing fees, since they are usually vertically integrated with, or control access to, the clearing infrastructure. They also make money by selling market data. Exchanges usually try to make a small profit- enough to finance investments in technology or facilities.

Traditional exchanges have been exposed to a moderate degree of competition. Often they enjoy the protection of regulatory or currency barriers. Once they achieve liquidity in a product, they usually achieve a fairly secure position, since in an open outcry world, liquidity is very sticky. Often they have a monopoly access to clearing, settlement, and depository facilities.

But this model is under attack.

Competition is intensifying, arising from the OTC market in derivatives or from proprietary trading systems for stocks.

The end-user community, the "buy side," is becoming increasingly institutionalized, bigger, more powerful, and more sophisticated in terms of market knowledge and trading strategies. The "sell side" is consolidating: securities firms and futures brokers are undergoing continued consolidation.

Brokers, dealers, exchanges, and interdealer brokers are all subject to relentless cost pressures.

Technology is a key driver. The cost of processing power will continue to decline rapidly, while the value of a network facility to its users increases exponentially with the number of users.

All this means that a new business model is emerging for exchanges.

Market access: Customers will get into the market from workstations connected to electronic networks.

Trading: It will be electronic.

Clearing and settlement: Clearinghouses will be unbundled from exchanges. They will clear both exchange-traded and OTC products. They will offer multiple levels of service, ranging from collateral management, as in a service bureau, to optional full-credit guarantees.

Membership: The meaning of exchange membership will evolve radically. In their search for liquidity and new products, exchanges will need to open up their membership to many more categories of members.

Mergers: Economies of scale and the cost advantages they engender justify mergers of exchanges.

Exchanges have several unique and lasting values, which go beyond supporting the trading function or providing clearing services. Among other things, they provide a regulated environment for trading, which normally offers transparency, some guarantee of fairness, and compliance. They also provide a convenient locus for regulators to carry out their duties.

They certify members, and membership in the exchange normally represents a badge of professionalism. They deploy a valuable R&D effort and forum for product design and standardization. They perform a valuable marketing and education service at the product level, which complements the brokers' marketing efforts.

These functions, carried out in an effective and professional manner, create the exchanges' reputation, their "brand" equity.

The evolution toward electronic trading may well diminish the exchange's value as a locale for trading, but it will not affect these other values. Just as electronic commerce ironically often reinforces the value of established brands, electronic trading may eventually help the world's best exchanges not only to survive but to conquer new markets.

What is clear is that the world has become much more competitive for exchanges and that they will need to go through a concerted effort of strategic repositioning. Those that fail to do so rapidly will be doomed.

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